Over the years, banking in Pakistan has been through many ups and downs after nationalizing of this vital institutional framework failed with disastrous results.
During 1990s, instead of reviving banking along market-oriented lines, regulation remained focused on demand management, which hiked up interest rates forcing marginally profitable businesses to close rather than revamp their cost structure thereby seriously weakening the economy precisely when competition was warming up, the world over.
By 2000 it became imperative to de-regulate banking on credible bases. Policy changes since 2000 that did away with the legacy of exchange controls and resource allocation targets, have allowed banks the flexibility they needed to become efficient and responsive to market demands.
There have been several positive developments that augur well for the future but benefiting effectively from these developments will require responsible and visionary leadership. However, the realization that in a deregulated environment the burden of pursuing socially acceptable goals for fairer distribution of wealth shifts from the state to the banking sector has not yet become the hallmark of Pakistan's banking.
Banks therefore continue to exhibit inadequate concern for achieving a rational relationship between credit expansion and GDP growth by channelling credit into productive investments.
An indication thereof is the government's call to the banking sector to participate in re-building the country's crumbling physical infrastructure through public-private joint ventures.
While banks must respond positively to this call, they would make a mistake by accepting the terms on which they are being asked to participate in this effort. Providing project finance through purchase of Municipal of District Government Bonds could prove disastrous.
Based on experience of the years gone-by, banks must closely examine the options for devising these financing vehicles so that, firstly, only viable projects are financed and, secondly, banks retain a major share in supervising on-time completion of these ventures.
Merely investing in Government Bonds would afford banks neither of these vital options. Banks would be well advised to directly finance these projects and dispose of them on BOT basis.
Not all banks appreciate the significance of the shift from working for the "shareholders" to serving the interests of all "stakeholders", and that pursuit of profit alone is not the hallmark of a responsible enterprise.
They also don't give the impression that they have learned from the experience of other countries (especially the US) the lesson that excessive indebtedness of businesses and individuals leads to serious consequences for the lending banks.
Recent business initiatives including financing the purchase of NSS certificates (until banned by the government), extension of auto finance loans far exceeding the capacity of auto assemblers to supply, financing suspect export transactions and multiple consumer loans to one individual by several banks (due to inadequate investigative leg work that relies the same source for repayment of all the loans) convey this impression.
A major development in the context of timely containment of such negative trends without stifling rational initiatives has been the establishment of a dialogue between SBP and the banking sector formalizing consultation with stakeholders before initiating regulatory changes.
This has facilitated major concessions being made to banks including the freedom to obtain term loans from banks abroad, extend foreign currency loans to domestic borrowers, trade freely in foreign exchange, gilt-edged paper and equities, and expand branch networks.
In spite of this dialogue there have been hiccups, some rather bad, the more disappointing being banks' inability to live with two-way interest rate volatility.
It manifests banks' failure to use the consultative process, firstly, for airing their reservations about official inflation estimates that were employed as the basis for lowering interest rates and, secondly, the consequences of interest rate volatility in the absence of rate hedging instruments.
Banks' inability to manage rate volatility has undermined saver confidence because, ultimately, savers were made to absorb the full impact of rapidly falling rates.
For the first time banks also faced the consequences of marking to market gilt-edged paper they earlier agreed to buy at unrealistically low yields. Hopefully, the experience will serve as a guide for future inter-action with SBP on this critically important subject.
Re-building saver confidence is a challenge that calls for a multi-pronged strategy. Banks are still grappling with this issue that threatens that their institutional character.
While, the focus of their strategies quite rightly remains cutting down on intermediation costs through administrative re-arrangements, indications of a discernable upsurge in efficiency that would benefit all stakeholders are yet to surface because returns to the savers remain below the current official rate of inflation.
More than banks, SBP has been conscious of the need for minimizing the adverse effects of interest and exchange rate volatility. Its recent initiative to permit banks to trade in Foreign Currency Options, Forward Rate Agreements and Interest Rate Swaps is a commendable move because on the one hand buyers of these contracts would be insured against losses from interest and exchange rate volatility and on the other they could also benefit from favourable rate volatility.
What banks need to appreciate is the fact that as providers of rate insurance through sale of these contracts to their customers they become the carriers of rate volatility risk.
Unless they equip themselves with requisite risk management expertise, they could expose themselves to substantial losses on sale of these contracts. It is imperative that these cost-cutting mechanisms succeed in achieving their goal because it would benefit both banks and their customers.
While banks continue aggressive loan marketing, a sobering development is tougher regulatory pressure for stiffer risk assessment, loan monitoring, adequate loss provisioning and raising bank equities to levels required by BIS Accord-II.
It seems to be working for the moment because loan delinquency has been contained at its 2002 level. But there are doubts about the sustainability of banks' expanding consumer loan portfolios along healthy lines.
2005 will expose the degree of diligence banks have been exercising in building their consumer loans portfolio. Large scale delinquency in this portfolio could weaken the prospects of raising bank equities by December 2005.
Missing this target could undermine SBP plans to begin compliance with the terms of BIS Accord-II. Should that happen international banking community will assign Pakistani banks a higher risk factor requiring them to pay escalated risk premiums for handling their transactions.
Banks must also not overlook the fact that revenues from traditional fee-earning services are falling because intense competition in trade is forcing businesses to stop using these services for the settlement of trade payments.
For instance, Letters of Credit - a high fee-generating instrument for the banks - is going out of fashion as businesses switch to settling trade payments directly. The same is true of many other traditional banking services.
Indications that this trend is impacting bank profitability are already there: banks are focusing on markets not yet served by them and, belatedly, are devising products and services for which latent demand existed all along.
For instance, services that cut down on customers' banking costs, paper work and need for personal interaction. But taking on this load will add new dimensions to the intermediation cost and squeeze profitability.
In spite of the foregoing, a commendable aspect of Pakistani banks has been the willingness to opt for technology changes to cut intermediation cost that has been eating into their profitability.
There is a definite realization that raising efficiency must be the hallmark of the banking system in the intensely competitive post-2004 period. However, making banks leaner (and adding to the ranks of the skilled unemployed) may be a cost that Pakistan would find hard to pay.
Commercial banks are experimenting with ideas and technology already tested in other developing countries. The initiative that includes increased automation, bringing vast branch networks on-line and offering electronic banking would cut operating costs, facilitate customer access, and bolster bank efficiency.
However, so far, only one large domestic bank has managed on-line connectivity with over 90 per cent of its country-wide network. The initial outlay on the infrastructure for offering these services is obviously high.
Given their network sizes, some banks may find investing in new technology beyond their means, at least for the moment, and opt for continuing with their existing infrastructure.
This could create two distinct classes of banks: the modern and highly efficient and the traditional and less efficient. Such a scenario could place these banks at a distinct disadvantage.
What banks need to focus on is not just automation. To support their consumer finance operations without suffering losses, they need skilled manpower for credible investigative work to make up for the lack of institutional arrangements there for.
Besides, consumer finance is not a short-term venture. For continuing it on a sustained basis, banks will need ever larger numbers of managers who must be hired now and developed into the future management of their banks.
Employee skills development is not the only thing banks need speed up. As de-regulation gains momentum in an environment of limited and often misleading information sources (remember the goof up by FBS in reporting the 2003-04 export figures?) for assessing the business characteristics of various markets, banks would be at ever increasing risk. It is therefore imperative that they revive and credibly streamline their archaic macroeconomic research departments.
